The Securities and Exchange Commission voted on June 28, 2018, to propose a new rule and form amendments intended to modernize the regulatory framework for exchange-traded funds (ETFs), by establishing a clear and consistent framework for the vast majority of ETFs operating today.  ETFs that satisfy certain conditions would be able to operate within the scope of the Investment Company Act of 1940 and to come to market without applying for individual exemptive orders.  The proposal would therefore facilitate greater competition and innovation in the ETF marketplace, leading to more choice for investors.

ETFs are hybrid investment products not originally provided for by the U.S. securities laws.  Their shares trade on an exchange like a stock or closed-end fund, but they also allow identified large institutions to redeem directly from the fund.  Since 1992, the Commission has issued more than 300 exemptive orders allowing ETFs to operate under the Investment Company Act.  ETFs have grown substantially in that period, and today the over 1,900 ETFs represent nearly 15% of total investment company assets.  Investors use ETFs for a variety of purposes, including core components of long-term investment portfolios, investment of temporary cash holdings, and for hedging portfolios.

“Many Main Street investors now use ETF investments to meet their financial goals. This proposal is an important step in moving a substantial portion of the $3.4 trillion ETF market under a rules-based framework that continues to provide the oversight and protections investors expect,” said Chairman Jay Clayton.  “The development of ETFs has given investors options that can more effectively meet their goals.  We should embrace such innovation and ensure that our regulatory framework allows for it, while being unwaveringly true to our investor protection mission.  We will continue to monitor this market, including in consultation with our Investor Advisory Committee and our Fixed Income Market Structure Advisory Committee, and welcome public comment.”

ETFs relying on the rule would have to comply with certain conditions designed to protect investors, including conditions on transparency and disclosure.  The SEC will seek public comment on the proposal for 60 days.

Highlights

The Commission is proposing a new rule and amendments to forms designed to modernize the regulatory framework for exchange-traded funds (“ETFs”).  Proposed rule 6c-11 would permit ETFs that satisfy certain conditions to operate within the scope of the Investment Company Act of 1940 (the “Act”), and come directly to market without the cost and delay of obtaining an exemptive order.  This should facilitate greater competition and innovation in the ETF marketplace by lowering barriers to entry.  The proposal would replace hundreds of individualized exemptive orders with a single rule subject to public notice and comment.  The proposed rule’s standardized conditions are designed to level the playing field among most ETFs and protect ETF investors, while proposed disclosure amendments would provide investors who purchase and sell ETF shares on the secondary market with new information.

Scope of Proposed Rule 6c-11

Proposed rule 6c-11 would be available to ETFs organized as open-end funds, the structure for the vast majority of ETFs today.  ETFs organized as a unit investment trusts, ETFs structured as a share class of a multi-class fund, and leveraged or inverse ETFs would not be able to rely on the proposed rule.

Conditions for Reliance on Proposed Rule 6c-11

Proposed rule 6c-11 would provide certain exemptions from the Act and also impose certain conditions.  The proposed conditions include the following:

• Transparency.  Under proposed rule 6c-11, an ETF would be required to provide daily portfolio transparency on its website.
• Custom basket policies and procedures.  An ETF relying on proposed rule 6c-11 would be permitted to use baskets that do not reflect a pro-rata representation of the fund’s portfolio or that differ from other baskets used in transactions on the same business day (“custom baskets”) if the ETF adopts written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders.  The proposed rule also would require an ETF to comply with certain recordkeeping requirements.
• Website disclosure.  The proposed rule and form amendments would require ETFs to disclose certain information on their websites, including historical information regarding premiums and discounts and bid-ask spread information.  These disclosures are intended to inform investors about the efficiency of an ETF’s arbitrage process.  Additionally, the proposal would require an ETF to post on its website information regarding a published basket at the beginning of each business day.

Rescission of Certain ETF Exemptive Relief

To help create a consistent ETF regulatory framework, the proposal recommends rescinding exemptive relief previously granted to ETFs that would be able to rely on the rule.  The proposal also recommends rescinding exemptive relief permitting ETFs to operate in a master-feeder structure, which very few ETFs currently utilize.  However, the proposal recommends grandfathering existing master-feeder arrangements involving ETF feeder funds, but preventing the formation of new ones, by amending relevant exemptive orders. Additionally, the proposal does not recommend rescinding exemptive relief that permits ETF fund of funds arrangements.

Proposed Amendments to Form N-1A and Form N-8B-2

The Commission is proposing several amendments to Form N-1A – the form ETFs structured as open-end funds must use to register under the Act and to offer their securities under the Securities Act – to provide more useful, ETF-specific information to investors who purchase ETF shares on an exchange.  The Commission also is proposing that ETFs organized as UITs provide the same information to investors on Form N-8B-2 – the form ETFs structured as UITs must use to register under the Act.

What’s Next?

The comment period for the proposed rule and form amendments will be 60 days after publication in the Federal Register.